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Will The Reforms Speed Growth In China?

Although still vague on the specifics, China's
Third Plenum
in November partially clarified the nature of the reforms that
Beijing is proposing for China over the coming year. Of course very
little was said in any of the related releases about the
difficulties, of which the most important are likely to be
political, in implementing these reforms, nor did we hear - not
unsurprisingly, I think - much about what specific steps Beijing
will take to address these difficulties. What has been surprising
to me is that many analysts - some of whom, but not all, recognize
how difficult implementation is likely to be - expect that the
reforms will unleash such a burst of productivity that growth rates
in China will be maintained or even raised from the current GDP
growth target of 7.5%.

This, I think, is extremely implausible. Much of what I have
written in recent months concerns the difficulty Beijing will face
in switching from one growth model, in which rapid growth
disproportionately benefits the elite at the expense of ordinary
households, to its alternative, in which much slower growth will
disproportionately benefit ordinary households at the expense of
the elite. This remains, in my opinion, a key consideration in
evaluating prospects over the next few years, but however
successfully the reforms are executed, I am convinced that analysts
who predict that we are about to embark on a decade of 7-8 % growth
both misunderstand the nature of China's transformation and ignore
the history of previous similar growth miracles.

It is almost impossible - in my opinion - that GDP growth rates
over the rest of this decade remain at or close to current levels.
I suspect that when growth rates drop, as they must, those who
claimed that current growth rates would be maintained will argue
that the reason their prediction was wrong was Beijing's failure to
implement the reforms correctly. While this may help save face, it
is, in my opinion, profoundly incorrect. On the contrary, I would
argue that if China's GDP continues to grow annually at above 7% in
2014 and 2015, this will be precisely because Beijing did not
implement the reforms. Successful execution of the reforms, in
other words, is exactly why growth rates will fall sharply.

To explain why, I want to list three of the thoughts I came away
with from the general reaction to the Plenum. First, while many
analysts hailed the reforms proposed during the Plenum as
extraordinarily "bold" and "innovative", in fact Chinese economists
have been debating these very reforms for a long time - even before
March 2007, when then-Premier Wen Jiabao famously described China's
economy as "unsteady, unbalanced, uncoordinated and
unsustainable."

Most economists now recognize that in recent years too much of
China's massive investment spending has been wasted on projects
with negative real returns - as happened in the late stages for
every country that followed a similar growth model. Debt,
consequently, is high and is growing much faster than China's
debt-servicing capacity. This is clearly unsustainable. Once China
reaches debt capacity constraints, like nearly all of its
predecessors did after many years of high growth, the country runs
the risk of a sudden and disorderly disruption in growth.

To resolve this problem China must implement reforms that
increase investment efficiency. This includes diverting resources
from the state sector to small and medium businesses. Beijing must
also increase the consumption share of demand, which requires above
all an increase in the household share of GDP.

Boiled down to their essentials, the economic reforms proposed
during the Third Plenum would do just that - by reforming the
currency and interest rate regimes, changing the allocation of
credit in the financial system, spurring innovation, reforming land
ownership and residency requirements, imposing stronger rule of
law, and perhaps even partially distributing state assets to
households. There is nothing surprising or unexpected about any of
these proposals.

The second thought I came away with from the consensus reaction
to the Plenum is, as I have said many times before, that historical
precedents suggest that the greatest challenge facing Beijing is
not in identifying the right set of reforms but rather in
implementing them. The reforms are relatively easy to prescribe,
but political opposition to the reforms is likely to be very
strong. To see why, we must understand how the alignment between
the interests of the economic elite and the needs of the economy
will change.

In the early 1980s, after many decades of war and economic
mismanagement, China's capital stock was far below its
institutional and social ability to absorb investment productively.
China urgently needed much higher levels of investment. Following
the experiences of a number of "growth miracle" countries - and
employing policies proposed by economist Alexander Gerschenkron
fifty years ago - China put into place policies that did just
that.

These policies, among the most important of which was the
repression of interest rates, all worked in the same way. They
diverted resources from the household sector, whose wealth
nonetheless grew rapidly as rural migrants flocked to new jobs in
the cities, into investment in infrastructure and manufacturing
capacity, much of which was directed or controlled by the state and
the economic elite.

While this resulted in at least two decades of solid and healthy
growth, the state sector and the economic elite benefited
disproportionately from the combination of rapid growth and
implicit transfers from the household sector. In fact, the GDP
share retained by ordinary Chinese households shrank dramatically
over the past three decades, while the share retained by the state
grew commensurately, of course, and income inequality widened. This
has nearly always been the case in the early stages of the
investment-led growth model - the state and the elite benefit
disproportionately.

Now that soaring debt is forcing China to abandon the model, the
relative distribution of economic benefits must be reversed.
Ordinary Chinese households must retain a growing share of future
economic growth, while the state and the economic elite must,
almost by definition, retain a shrinking share. This is ultimately
what it means to rebalance the economy and - as happened in other
countries that followed this growth model - this is why the reforms
are likely to be politically difficult. After thirty years in which
the interests of the elite were positively aligned with the
interests of the country, the reforms now imply a negative
alignment of their interests.

How much growth can we expect?

My third thought, and this is the most important point, is about
the pace of post-reform growth. Many economists believe that a
successful implementation of reforms must guarantee growth of 7% or
more during the rest of this decade, but this probably represents
the greatest piece of confusion about China's adjustment.
Here
is my Carnegie Endowment colleague, Yukon Huang, with one of the
more optimistic predictions:

Despite the vagueness of the communique, the "decision"
provided a comprehensive reform programme that, if acted upon,
will absorb the energies of this generation of senior leaders
and beyond. Ironically, rigorous implementation of these
reforms will alter market incentives so that annual gross
domestic product growth in the coming years could rise to
8-plus per cent even as the recent Central Economic Work
Conference debated whether to lower the official target to 7
per cent to reinforce that quality now matters more than
quantity.

Although not many other analysts are predicting growth rates
above 8%, certainly there are widespread expectations that if the
reforms are implemented, growth will remain above 7%. Arthur
Kroeber from Dragonomics in a
Foreign Policyarticle
expects that the reform program "is likely to be effective in
sustaining the nation's economic growth" while the
Financial Timescites
one analyst as suggesting that growth will stay in the 7-8%
range:

However, data released on Tuesday confirmed thatChinese growth momentum remains robust, with investment
slowing but retail sales picking up. The economy is believed to
be growing roughly on par with the 7.8 per cent year-on-year
pace it notched up in the third quarter.

This has put Lu Ting, an economist with Bank of America
Merrill Lynch, in the camp that believes there need not be a
trade-off between growth and reforms. "Reforms can also support
growth, especially those reforms that make growth more
efficient. So I don't understand why people think reforms have
to be negative for growth," he said.

There are however at least three very strong reasons, I think,
to argue that as the reforms are implemented, growth rates must
drop sharply.

1. Growth rates underpinned by tremendous credit expansion,
which acts to increase demand, are unlikely to be maintained in a
period of relative deleveraging, during which demand is
reduced
.

It is widely acknowledged that perhaps the most important reason
to change the Chinese growth model is its excessive reliance on
debt to generate growth. Debt has soared in recent years, to the
point where many economists simply look at credit growth in the
current quarter in order to determine what GDP growth over the next
few quarters are likely to be.

But as China deleverages, growth in demand must drop sharply.
After all, if economic growth over the past several years has been
goosed by rapid credit expansion, deleveraging must have the
opposite effect. It is strange that economists who acknowledge that
the current growth model is overly dependent on debt have failed to
understand that its reversal will have the opposite impact. If it
did not, it is hard to explain why anyone would consider debt to be
a problem in the first place.

2. The failure by Chinese banks to recognize misallocated
investment must overstate past GDP growth, in the same way that
this overstatement must be reversed in the future, either because
the bad debt is explicitly recognized, or because it is
implicitly written down over the debt repayment period.

If China currently has wasted significant amounts of investment
spending, it is clear that much of the accompanying bad debt has
not been written down correctly. Bad loans are almost non-existent
in the banking system - that is they have not been recognized in
the form of reserves or write-downs - and there have been no
significant bankruptcies.

There may be good reasons for this. If a loan has been made to
fund a project whose economic value is less than the economic cost
of the investment, economists should treat it as a bad loan whose
negative present value must be written down. However if the lending
bank believes that the government implicitly or explicitly backs
the loan, the bank does not need to write it down.

But while the bad loan might not represent a loss to the bank,
it does represent a loss to the country, and the amount of that
loss should be deducted before the country's GDP is calculated. If
Chinese banks have not correctly written down the bad debt,
however, past GDP growth must be overstated by an amount equal to
all the bad loans that have not been written down - a fairly large
number that may amount to as much as 20-30% of GDP.

But the failure to recognize the loss does not mean that the
loss does not exist. The losses implicit in the bad loans must (and
will) be written down over the future, either explicitly, in which
case they will result in a direct deduction to GDP growth, or
implicitly, in which case they will require implicit and hidden
transfers from one part of the economy or another (usually the
household sector) to cover the gap between the "real" cost of
capital and the nominal (subsidized) cost of capital. This transfer
must reduce future growth.

The point here is that if credit is a problem in China -
something no one doubts - it must be a problem because of wasted
investment that has yet to be recognized, otherwise it would have
resulted in negative GDP growth today. Failure to recognize the
investment losses will, of course, artificially boost GDP growth
today, but it must also artificially reduce GDP growth tomorrow as
the recognition of those losses is simply postponed, not
eliminated. The failure of many economists to recognize that wasted
investment has a cost - even as they recognize that investment has
been wasted - has caused them both to misunderstand the
relationship between wealth creation and GDP and to understate the
future impact of this overstated GDP.

Debt matters, and the only time it can be safely ignored is when
debt levels are so low, and the borrower is so credible, that it
creates no financial distress costs and has a negligible impact on
demand. Neither condition applies in China, and so any prediction
that ignores debt is likely to be hopelessly muddled. In fact, I
would like to propose a simple rule. Any model that predicts
China's future GDP growth must include, if it is to be valid, a
variable that reflects estimates of the amount of hidden losses
buried in the banks' balance sheets. If it does not, it cannot
possibly be a valid model to describe China's economy, and its
predictions are useless.

3.
The same mechanisms that forced up China's growth rates created
China's imbalances, and reversing the latter means also reversing
the former.

China's astonishing growth during the past three decades is
partly the result of a system that subsidized growth with hidden
transfers from the household sector. These transfers are at the
root of the current imbalances, and once reversed, so that China
can rebalance its economy towards healthier and more sustainable
sources of demand, the very processes that turbocharged growth will
no longer do so.

If growth has been healthy and sustainable, in other words,
there would be no need for Beijing to change its growth model - in
fact it would be foolish to do so. If growth has not been healthy
and sustainable, this is almost certainly because it has been
artificially propped up, and if the reforms are aimed at unwinding
the mechanisms that artificially propped up growth, then subsequent
growth rates must be substantially lower.

Low interest rates, low wages, an undervalued currency, nearly
unlimited access to credit for state-owned enterprises, a relaxed
attitude to environmental degradation, and other related conditions
were both the source of China's ferocious growth as well as of
China's unprecedented economic imbalances. Reversing these
conditions will rebalance the economy, but will do so while
lowering growth in the obverse way that these conditions had
accelerated growth.

One of the most obvious places in which to see this is in excess
capacity in a wide range of businesses. It is clear that Beijing
recognizes the problem of excess capacity. Here is
Xinhua
on the subject:

Tackling excess capacity will be one of the top tasks on
China's economic agenda in 2014, as the issue becomes a major
challenge to maintaining the pace and quality of economic
growth. "The Chinese economy still faces downward pressure next
year," the Central Economic Work Conference pointed out on
Friday, citing the capacity issue weighing down some sectors as
one of the major challenges facing the world's second-largest
economy.

It should be obvious that building excess manufacturing
capacity, like building up inventory, is a way of propping up
growth numbers today at the expense of tomorrow's growth numbers.
Closing down excess manufacturing capacity must be negative for
growth in the same way that building it was positive.

These three conditions, which are the automatic consequences of
the reform process - deleveraging, writing down unrecognized
investment losses, and reversing policies that goosed growth rates
- must lead to much slower growth. In theory these conditions can
be counterbalanced by an explosion in productivity unleashed by the
reforms. When analysts claim that growth rates will not slow if the
reforms are implemented, this must be implicitly what they
mean.

But this is unlikely to be the case. For the net impact of the
reforms on growth to leave China's GDP growth unchanged, or even to
accelerate, the amount of productivity that must be unleashed by
the reforms is implausibly, even extraordinarily, high. What is
more, the positive impact on productivity must emerge almost
immediately. Longer-term productivity improvements - for example
those generated by education, land, and hukou reforms, or reforms
to the one-child policy, or a speedier and more efficient
urbanization process - do not count.

I am so convinced that the implementing of these reforms must
result in slower growth - if only because it is impossible to find
a single relevant case in history in which the adjustment following
a growth miracle did not include an unexpectedly sharp slowdown in
growth - that I would propose that we can judge the forceful
implementation of the reforms inversely with GDP growth. If China
is able to impose an orderly adjustment quickly, its GDP growth
rate will slow substantially for several years.

GDP growth rates of 7% or more, on the other hand, will suggest
that credit is still rising too quickly and that China has
otherwise been unable to implement the reforms, in which case China
is likely to reach debt capacity constraints more quickly. Growth
of 7% for the next few years, in other words, is almost prima facie
evidence that China is not adjusting.

Note:This is an abbreviated version of the newsletter that went
out nearly four weeks ago.

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